Too Much Confidence

Bernanke Wants Us to Trust His Poor Record

Whenever you hear government officials say that they are “confident” about the ability to tackle some kind of pending crisis, you should always beware-that’s usually when something bad is about to happen.

In response to the financial crisis, the Federal Reserve has taken itself into unchartered water, more than doubling its balance sheet by buying up toxic debt and injecting huge amounts of liquidity into the banking system. As a result, banks are sitting on huge stockpiles of cash that, if released into the marketplace all at once, could cause some significant inflation problems, leading straight into a new crisis.

But Fed Chairman Ben Bernanke says he and his staff are “fully confident” they will be able to avert rampant inflation because they have “spent considerable effort” thinking about what they should do to avoid this from happening. Such a brazen statement could only come from someone who truly believes his c’est le coq du village lore.

The Fed faces a very difficult challenge: walking the tight rope of interest rate policy. Tightening too fast will cause the economy to contract and could set off a “w-shaped” recession. Fears of this result are particularly heightened given the lack of stability in the, government-supported recovery so far. Tightening too slow, however, could result in high inflation.

There is ample reason to question Bernanke’s confidence in himself and the Fed. In the years leading up to the financial crisis, Bernanke was equally confident that the Fed would be able to counter any crisis and that the U.S. financial system was on a sound footing. As he said in 2002, while a Fed Governor, “the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow.” He added:

“A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.” (Emphasis added.)

Former Fed Chairman Alan Greenspan, Bernanke’s predecessor, was similarly confident that the U.S. financial system was robust and resilient. During Greenspan’s tenure he was confident that the Fed had a good grip on the economy and that it would continue to do so. Shortly before he stepped down as Fed Chairman, he expressed confidence that “the central bank will meet the challenges that lie ahead.”

He also had “little doubt” that his successors at the helm of the Fed “will continue to sustain the leadership of the American financial system,” even though he expressed concerns that some difficulties lied ahead. At the very least, his prediction that Bernanke would continue his legacy turned out to be true.

Back in 2002, the “Maestro” was also quite confident that there was no such thing as a housing bubble in the making: “We’ve looked at the bubble question, and we’ve concluded that it is most unlikely.” And in 2005, when the booming housing market made it hard to deny that at least something was going on, he told that the Fed saw “a lot of local bubbles,” but he was quite sure there could be no such thing as a “national bubble.”

He wasn’t the only one who was confident, though. The National Association of Realtors and the National Association of Home Builders echoed the Chairman’s confidence in the U.S. housing market, saying in 2002, “there is no such thing as a current or impending house price bubble.” If anyone should have see the bubble coming, it should have been the ones building and selling the homes. Yet, the height of expertise failed here as well.

Another incurable optimist is Congressman Barney Frank. The chairman of the House Financial Services Committee was a driving force behind the efforts to expand “affordable homeownership” during the housing boom. As late as July 14, 2008, just weeks before his two coddled children Fannie Mae and Freddie Mac were about to collapse, Frank was pretty confident that “Freddie Mac and Fannie Mae are fundamentally sound. They’re not in danger of going under… I think they are in good shape going forward.”

As it turned out, they were in terrible shape, which is why the federal government took full control over the two entities and put them on life support. The shares of Fannie Mae and Freddie Mac, which peaked at $87.81 in December 2000 and $73.70 in December 2004, respectively, are now trading at around one dollar. So far the government has pumped over $145 billion into the two government-sponsored enterprises, and the expected future losses are estimated to be several times that amount.

Rep. Frank is still optimistic, this time about the prospects of a recovery, saying: “I have a lot of confidence in [Treasury Secretary] Geithner and [National Economic Council Chairman] Summers.” President Barack Obama, for his part, is not only confident-a word frequently heard in speeches-but also says that he is “very confident” in his economic team’s ability to fix what needs to be fixed. He is also “very confident” that the political leadership of this nation is “going to be in position to design the regulatory authorities that are necessary to prevent this kind of systemic crisis from happening again.”

America isn’t the only place where there is a lot of confidence. China’s economy is going through a massive boom in credit and asset prices, following in the wake of last year’s huge monetary stimulus to get the economy out of a downturn. Yet, in a recent speech, China’s Premier Wen Jinbao says he is “confident” that he can manage the boom in property prices. At the same time the Chinese government is boosting the supply of affordable housing and will use “economic and legal measures” to curb speculation.

Like Bernanke, Chinese officials assure us they have everything under control, and will be able to exit last year’s monetary stimulus through gradually deflating the bubble. They will do so by increasing reserve requirements for the banks, thereby trying to steer bank lending onto a firmer footing, and a host of fiscal policies including property tax reforms.

But this confidence is surely misplaced. As British journalist Andreas Whittam Smith said in January 2008, on the eve of Bear Stearns collapse and the worst stage of the financial crisis, “History records no case where the bubble gracefully deflated, accompanied by a slight hiss of escaping optimism. The speculative episode always ends with a loud explosion.” China would be wise to head these words.

Karl Marx once said that history repeats itself, first as tragedy, second as farce. Unfortunately, misplaced faith in the omniscient wisdom of government officials-or even private sector experts-isn’t anything new. And as our leaders express confidence in their abilities, history is repeating itself not for the second time, but for the umpteenth time. The reality is that, while government officials can sometimes manage crisis and anticipate the market, a broken clock is also right twice a day. Even the massive brain trust at the Federal Reserve must recognize that it cannot know everything in the market, and understand the constantly evolving cycle of demand and preferences that drive the economy.

Timing an exit as Bernanke and the Fed are trying to do is by far more art than science. Yet, ask Bernanke why we should now trust that he has the economy well under control, since he clearly didn’t the last time he said so, and he would likely say, “We’ve learned. This time is different.” Unfortunately, as Sir John Templeton says, those last four words are the most expensive in the English language.